2 Critical Factors for the Auto Industry in 2017

By Daniel Miller Markets Fool.com


Image source: Getty Images.

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There was just enough gas left in the tank for the automotive industry to finish off 2016 in style. Last month, total industry sales hit a seasonally adjusted annual rate of 18.38 million, the highest rate in 2016 and the fifth-highest in history. That was just enough to top the previous sales record set in 2015 by 56,000 units. However, sales are plateauing after the seventh straight year of annual gains, and if December was any indication, investors would be wise to focus on the following two factors in 2017.

Inventory

To better understand what we don't want to see in 2017, it's important to look at recent inventory trends. Right before the holiday season, inventories at General Motors (NYSE: GM) and Ford Motor Co. (NYSE: F) were elevated compared to preferred industry levels of about 60 days' supply. At the end of November, GM's had 87 days' worth of supply in inventory, far above the 70 days' supply it held the same date in 2015. According to Automotive News, GM's inventory increased a steep 28% between Aug. 1 and Dec. 1 to its highest level in nearly nine years.

Now, to be fair, it's not unusual for inventories to be elevated prior to the holiday season, provided the supply level declines post-holiday, and that's exactly what's happened -- and something we want to see continue in 2017. As of Jan. 1, Ford's supply dropped from the 83 days' worth in the prior month to 70 days'. General Motors' inventory took an even sharper drop, from 87 days' supply to 71 days'.

Part of that was due to a strong holiday selling season, and part of it was due to a number of layoffs, which nobody likes to see but which remain a necessary part of business. Toward the end of 2016, GM announced it was laying off 2,000 workers as it suspended third shifts at two plants. It also announced it would shut down production at five plants during January for periods of one to three weeks.

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Automaker inventories will be critical to watch in 2017, and seeing how the automakers ended 2016 gives hope for investors that inventories will continue to balance out even if that means tough decisions for employees and plants. As the market continues to plateau, if these inventories take a turn for the worse and bloat out of control, it will put immense pressure on automakers to increase incentive spending to move the vehicles, and that destroys profits.

Incentives

Despite the positive moves in inventory levels, the opposite was true for profit-eroding incentive spending last month. According to Automotive News, auto analytics company ALG estimates that the average incentives on new vehicles soared 20% in December to $3,673.

Two Detroit automakers exceeded the industry's average percentage increase, with Fiat Chrysler Automobiles (NYSE: FCAU) jumping 22%, compared to the prior December, to $4,291 and Ford jumping 34% to $4,190. Although GM's year-over-year increase was less than the industry average at only 14%, its average total spending was higher, at $4,611.The caveat here is that the cause of these elevated incentives was almost certainly related to selling an enormous number of full-size trucks. Those trucks carry much higher average transaction prices, and thus higher incentives. Still, December's 20% increase across the industry is a trend investors do not want to see more often in 2017, if at all.

"Substantial incentive hikes ... haven't resulted in retail growth, while inventories continue to grow," said Tim Fleming, an analyst at Kelley Blue Book, according to Automotive News. "An increasing supply of used cars, especially off-lease units, is already putting pressure on residual values, which could impact the sustainability of today's high levels of leasing. We are looking for manufacturers to cut production in the new year to better match slowing consumer demand and alleviate the need for elevated incentives."

The auto industry might not set a new sales record in 2017, and if contraction occurs, it will put added pressure on automakers to win customers and protect their market share. Investors will absolutely have to keep an eye on inventory levels in hopes that they move closer to 60 days' supply, and that incentive spending doesn't consistently move higher compared to 2016 levels. If the industry can balance those two factors, 2017 will be another extremely profitable year for all involved; if not, it will justify the low valuations Wall Street has put on Detroit automakers.

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Daniel Miller owns shares of Ford and General Motors. The Motley Fool owns shares of and recommends Ford. The Motley Fool recommends General Motors. The Motley Fool has a disclosure policy.